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Buffett slams Black-Scholes and 'flat earth' economists

Black-Scholes | Buffett slams Black-Scholes and 'flat earth' economists Ian Fraser

This is the second part of Ian Fraser's blog on Warren Buffett’s letter to shareholders in insurance conglomerate Berkshire Hathaway. Here, Fraser examines the Omaha-based investor’s thoughts on derivatives pricing, his views on academic economists, leverage, and hedge funds. (Read part one here.)

Warren Buffett speaks a phenomenal amount of sense about investment and investment-related matters, and his latest letter to shareholders in Berkshire Hathaway, where he has been chairman since 1970, is true to type.

Not only does the 'Oracle of Omaha' slam the Black-Scholes formula for derivatives pricing, he also questions the integrity of academic economists and hedge-fund managers and highlights some of the dangers of leverage.

Buffett said that the accounting obligation to use Black-Scholes, which he sees as deeply flawed, meant that Berkshire had to increase its balance-sheet liability during the year to December 2010 from $8.9bn to $9.6bn, a change that, after the effect of tax accruals, reduced the group’s net income for the final quarter by $455 million. Buffett said,

"Both Charlie and I believe that Black-Scholes produces wildly inappropriate values when applied to long-dated options. We set out one absurd example in these pages two years ago. […] We continue, nevertheless, to use that formula in presenting our financial statements. Black-Scholes is the accepted standard for option valuation – almost all leading business schools teach it – and we would be accused of shoddy accounting if we deviated from it.

"Moreover, we would present our auditors with an insurmountable problem were we to do that: They have clients who are our counterparties and who use Black-Scholes values for the same contracts we hold. It would be impossible for our auditors to attest to the accuracy of both their values and ours were the two far apart."

He said that both he and Munger are confident that Berkshire’s derivative liabilities are much lower than the figure derived from Black-Scholes. “Our inability to pinpoint a number doesn’t bother us: We would rather be approximately right than precisely wrong.”

Buffett swiftly moves on to lambast university economics departments (which also came under heavy fire in Charles Ferguson’s movie about the financial crisis Inside Job). Buffett cannot believe that so many clung onto the “efficient markets hypothesis” (the hypothesis that exploiting stockmarket information cannot bring an investor unexpected returns, since share prices already reflect all available information about future economic trends and company profitability (!!)) throughout the 1970s and 1980s even when powerful facts emerged that proved it to be hogwash.

Buffett said the university economics departments response was to dismiss the new facts as “anomalies”. (For good measure, the 80-year-old value investor extraordinaire adds that: “I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.”)

Buffett said university academics’ current practice of teaching Black-Scholes as though it were “revealed truth” needs more than just re-examination. He said that rather than learning how to value an option, business school students ought to be learning how to value a business, since that’s what investing is all about.

Moving on to the subject of leverage, Buffett said it can give an individual or an enterprise an (often deceptive) aura of success, but that it can also be lethal, especially when credit markets freeze up as they did in September 2008.

"Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

"Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed.
When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees."

Buffett also cast aspersions on the integrity of many hedge fund managers (so-called “general partners”) who he claims often take their investors (“limited partners”) for a ride. He wrote:

"The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains. Sometimes these same general partners thereafter quickly started another fund so that they could immediately participate in future profits without having to overcome their past losses. Investors who put money with such managers should be labeled patsies, not partners."

I found this last section of Buffett's letter fascinating - it immediately got me thinking of the way in which a generation of bankers “walked away rich” despite having driven their institutions over a cliff.

The difference between them and the hedgies is that, whereas the "limited partners" who invest in hedge funds have a choice, and arguably therefore have only themselves to blame, the taxpayers who were forced to bail out bankrupted banks had zero choice in the matter.

Further reading on Warren Buffett, Black-Scholes, derivatives and academic economists:

Tags: derivatives , economists , financial crisis , hedge funds , leverage , transparency , US , Warren Buffett
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